x When the economy has lots of unemployed workers, we say we are in a recession Æ Recessionary gap.
x If the gap is large enough, there will be pressure for prices to fall Æ Deflationary gap.
x It occurs when the equilibrium level of output (Y*) is greater than the full-employment level, i.e., Y* > YFE.
x This means that the economy is producing more output than is normally associated with full employment.
x How? Hire more workers or ask their workers to work over time.
x The economy is “too hot”! The economy overheats Æ there will be pressure for prices to rise Æ Inflationary gap.
Endogenous Budget Balance & Output Gaps
x In this section, we connect the notion of output gaps with the notion of endogenous budget balance.
Relationship between Budget Balance and National Debt
x Recall, BB = T – TR – G.
o If BB < 0, the government runs a budget deficit.
o If BB > 0, the government runs a budget surplus.
x However, each time when the government runs a budget deficit, it needs to find ways to finance its deficit.
x Question: How does the government finance its deficit?
x Answer: Borrowing (issue government bonds)
x Question: What is the problem if the government runs persistent budget deficit?
x Answer: Every time the government borrows from the public, the stock of national debt increases.
o This debt must be “serviced”, i.e., the government has to pay interest on its debt (there is no free lunch).
o This interest payment uses up some tax revenue needed to run public programs.
o Government has to cut services (decrease funding on some programs or cancel some programs) or increase taxes or do both.
o Program cuts hurt Canadians. Higher taxes also hurt us (remember excess burden from ECMA04).
* Luckily, most of the government bonds are held by Canadians (i.e. we owe ourselves money).
x Let’s agree that persistent budget deficits are bad since national debt increases.
Structural Deficit vs. Cyclical Deficit
x The budget balance, BB = (T0 – TR0 – G) + (t1 + tr1) Y, is endogenous; it changes automatically when Y changes.
x Implication: We need to separate a deficit during a recession which is natural from a persistent deficit even if the economy is
operating at full employment (which is bad).
x If the government runs a deficit when Y = YFE, then we have a structural deficit.
x If there is no deficit or surplus at YFE, but the government runs the occasional deficit when Y < YFE, then we have a cyclical deficit.
x In other words, we need to worry if we have a structural deficit but not to worry if we have cyclical deficit.
x Ideally, we should run surpluses during good times (when Y > YFE) and deficits during bad times (when Y < YFE).
Relationship between Output Gaps and Budget Balances
x Assumption: There is no structural deficit, i.e., BB = 0 when Y = YFE.
x We ask the question: What do we do if there is a deflationary/recessionary gap or an inflationary gap?
o Can the government do something about it?
x The answer is YES! The government can adjust its balance to bring Y back to YFE.
x Recall, AE = AE0 + cYY, where AE0 = C0 + I0 + G + X0 + c1TR0 – c1T0
Y = c1 (1 – t1 – tr1) – im1
x Changes in G, TR0, or T0 will affect AE0. A change in AE0 will lead to a change in Y*. (There is room for the government to use
fiscal policy to smooth out the business cycle.)